BrealeyMyers

Brealey/Myers: Principles of Corporate Finance (1996 & 2000) Chapter 1: Why Finance Matters •

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The financial manager is anyone responsible for a significant corporate investment or financing decision. He decides on: o What investments should the firm make? (answered by the firm's investment or capital budgeting decision) o How should it pay for those investments? (answered by the firm's financing decision) A good capital budgeting decision is one that results in the purchase of a real asset that is worth more than it costs. This is an asset that makes a net contribution to value. Financial managers therefore need to know how investors value a firm and how financial markets work, as financing decisions cannot be separated from financial markets. For example, he must know theories on how financial choices (e.g., debt or stock) affect value or he must understand how interest rates are set and how loans are priced in case of huge debts that last a long time. Financial managers have the responsibility of looking into whether an opportunity is worth more than it costs and whether the debt burden can be safely borne. He copes with time and uncertainty factors. Flow of cash between financial markets and the firm's operations: 1. Cash is raised from the financial market by selling financial assets to investors. 2. This is invested into the firm's operations and is used to purchase real assets. 3. Cash is generated by the firm's operations. 4. a) Cash is reinvested. b) Cash is returned to investors. Note: The financial manager stands between the firm and the financial markets. Specializations: o Treasurer: obtains finance, manages the firm's cash account and its relationships with banks and other financial institutions, makes sure that the firm meets its obligations to the investors o Controller: checks that the money is used efficiently, manages budgeting, accounting and auditing

Chapters 2 & 3: Present Values and the Opportunity Cost of Capital • • • •

Objective of the capital budgeting decision: to find real assets that are worth more than what they cost Present value calculation: To arrive at the PV, expected future payoffs are discounted by the rate of return denoting the opportunity cost of capital, which is the return forgone by investing in the project rather than investing in the capital market. What about risk? To account for risk, we have to think of expected payoffs and the expected rates of return. Decision rules: 1. NPV rule: Accept investments with + NPVs. And invest so as to maximize the NPV of the investment. This is the difference between the discounted value (PV) and the initial investment. 2. Rate of return rule: Accept investments with rates of return above the opportunity cost of capital; that is: [(expected value - initial investment)/initial investment] > opportunity cost of capital In view of productive opportunities, invest up to the point at which the marginal return

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on investments is equal to the rate of return on investments in the capital market. This is the point of tangency between the interest-rate line and the investment-opportunities line. Note: The opportunity cost of capital is not: 1. The risk-free rate. The investment is risky! 2. The rate imposed on the loan provided by the project. This rate does not reflect the health of the existing business. It does not also matter whether the loan is made or not. The decision maker still has to decide whether to invest in the project or in an equally risky stock. Irving Fisher: Managers do not need to know anything about the personal tastes of their shareholders and should not consult their own tastes. Their task is to maximize NPV. Copeland/Weston: Exchange opportunities permit borrowing and lending at the same rate of interest. Thus, different shareholders will be unanimous in their preference as regards production decisions. Managers will then choose to invest until the rate of return on the least favorable project is exactly equal to the market-determined rate of return.

Chapter 5, 6 & 11: Why NPV Leads to Better Investment Decisions (B/M and C/W put together) •

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Criteria for the qualifaction of captial budgeting techniques: (Copeland/Weston) 1. All CFs! (and only CFs, not accounting profits) (Brealey/Myers) 2. Discount at the opportunity cost of capital. 3. From a mutually exclusive set, select the one which maximizes shareholder wealth. 4. From an independent set, value additivity must hold so that projects may be considered independently. Payback: How long does it take for an investment's return to cover up fully the initial investment? Rule: Choose the project with the shortest payback (C/W) Problems: o Not all CFs are included o Gives equal weight to all CFs before the payback date and no weight to subsequent flows (B/M) Discounted payback: How long does it take for an investment's discounted returns to cover up fully the initial investment? This is not a big improvement from the payback method! Accounting rate of return: How much returns does an investment yield relative to the invested capital? Rule: Choose the highest average after-tax provided by the intial cash outlay. (C/W) Problems: (C/W and B/M) o Uses accounting profits, not CFs o No time value of money, no discounting Internal rate of return: the rate at which the PV of outflows equals the PV of the inflows (NPV = 0) = the rate of return that a project is returning to the firm; the true rate of return of a longlived asset Rule: Accept any project that has an IRR > opportunity cost of capital (C/W) Problems: o Not all CFs have NPVs that decline as the discount rate increases. In such cases, the IRR could be lower than the opportunity cost of capital. (B/M) o Assumes that IRR is the time value of money (reinvestment rate assumption). The reinvestment rate should be the opportunity cost of capital. (C/W)

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o Assumes that the opportunity cost of capital is the same for all CFs. Short-term interest rates are normally different from long-term interest rates. o Values of projects change when we combine them. Value additivity does not hold. o Multiple rates of return if the CF direction changes more than once or perhaps there will be no IRR at all! (C/W and B/M) NPV is then the better decision rule because: o It solely recognizes all CFs. o It recognizes the time value of money; discounts at the opportunity cost of capital. o Positive NPVs add value to shareholder wealth. (C/W) When we discount CFs by WACC and achieve positive NPVs, we are saying that the CFs are enough to satisfy the required rate of return of creditors, repayment of the face amount of debt, and payment of expected dividends to shareholders. (B/M) o Value additivity holds. A note on mutually exclusive projects (C/W): If the value additivity principle holds, then we can choose between two mutually exclusive projects, regardless of their being independently considered or their being together in a valuation. If we adopt the NPV rule, the value of the firm is the sum of the values of the separate projects. If we use the IRR, we have to consider all possible combinations of projects and choose the combination with the greatest IRR. If there are five projects, management has to consider 32 combinations! Where positive NPVs come from (Chapter 11): o economic rents = profits that more than cover the opportunity cost of capital. The NPV of an investment is simply the discounted value of the economic rents that it will produce. Rule: Avoid expansion when competitive advantages are absent and economic rents are unlikely. Note: You do not have to apply DCF when market values are readily available. Some Considerations: o Inflation: Just be consistent in your treatment of inflation. If the discount rate is in nominal terms, then the CFs must be in nominal terms. Relationship between the nominal and real interest rates: (1 + rnom) = (1 + rreal) ( 1 + inflation rate) o Capital rationing: When funds are limited, a firm cannot simply choose projects with positive NPVs. It has to select the projects that offer the highest NPV per initial investment. Profitability index = NPV/investment Advantage: simple Disadvantages: § What if more than one resource is constrained? § Cannot cope in cases where there are mutually exclusive projects or when one project is dependent on another Other methods: Use of variables or constraints in linear programming. But: § Expensive § Good data? § Assumes that all future investments are known § Cannot be used when large, indivisible projects are involved. Soft rationing: Provisional limits are adopted. Hard rationing: Market imperfections impose the restrictions.

Chapter 10: A Project is Not a Black Box ==> Know it well! • Sensitivity analysis: Express CFs in terms of key project variables. Subject them to pessimistic and optimistic scenarios and see how bad the situation can get before the project begins to lose money (break-even analysis). o Disadvantages: § Ambiguous results. What does optimistic/pessimistic mean? § Underlying variables are likely interrelated. Of what use is looking at an effect in isolation of the others? • Monte Carlo simulation: Consider all possible scenario combinations and inspect the entire distribution of project outcome results. o Steps: 1. Model the project. 2. Specify probabilities. 3. Simulate the CFs. o Disadvantages: § Costly and time-consuming § The more realistic, the more complex § Two unrelated projects can be combined in the simulation. As a result, correlated risk can reduce the total risk figure. This leads to the violation of the value additivity principle. The portfolio risk will be smaller than the sum of the risks of two separate projects. This will encourage joint project proposals, although the projects are separate. § The risk-free rate is normally used to discount the CFs. This is not the opportunity cost of capital. § No strategy taken up; probably implicit but not the optimal one; only a "business as usual" strategy § The distribution arrived at depicts losses that may not even be realized. Extremes should be analyzed/treated with extreme caution. o Lesson: Simulation should be regarded as a way of obtaining information about expected CFs and risk. The final decision should involve the NPV. • Decision Trees: To analyze projects that involve sequential decisions. Problems are solved by thinking about what would be done next. Prospects are schemed and given their probabilities. The total expected value at a particular point in time is then calculated. o Disadvantages: § Complexity of considerations (depends on the analyst) § All possible future events will never be displayed anyhow. § No idea provided as to how the options are to be valued o Lesson: Decision trees allow the explicit analysis of possible future events and decisions. This should be judged not on the basis of their comprehensiveness but on whether they show the most important links between today's and tomorrow's decisions. Chapter 12: Organizing Capital Expenditures •

Steps in the investment process/investment performance evaluation: 1. Preparation of an annual capital budget, which is a list of planned investments by plant and division. (In principle, this should be a list of all positive NPV projects.) 2. Appropriation requests with back-up info for project authorization; decision via DCF or other methods

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3. Control projects in progress. Control is established by accounting procedures for expenditures. 4. Post-audit. Check on the progress of recent investments. In evaluating operating performance, there are two possibilities: a) Compare actual operating earnings with projected CFs. b) Compare actual profitability with absolute standards of profitability (cost of capital). Points to consider: 1. Ensure that the forecasts are consistent. Establish forecasts of economic indicators and particular items that are important to the firm's businesses and use them as basis for all project analyses. 2. Eliminate conflicts of interest. The main goal is to maximize shareholder wealth. Problems could arise when book returns are given importance or when the attitudes toward risk are different, esp. if these have some relation to management performance measurement and compensation. 3. Beware of forecast bias, e.g., overoptimism. 4. Get the right info. Projects cannot be judged correctly, unless the true cost of capital is known. 5. Recognize strategic fits. A firm's capital investment choice should reflect both "bottom up" and "top-down" processes – capital budgeting and strategic planning. Incentives for performance: The ideal scheme is to let management bear all the consequences of their actions. They should however not be exposed to fluctuations in value over which they have no control, e.g., tying up management compensation with stock price movements. Performance measurement: Use of accounting measures Advantages: o based on absolute performance rather than on performance relative to investor expectations o makes possible the measurement of the performance of junior managers whose responsibility extends to a single division or plant Disadvantages: o partly within management control o can be biased in measuring true profitability. For ex., ROI = [after-tax operating income / net (depreciated) book value of assets]. This is biased upward for companies with intangible investments, such as R&D, because accountants do not put these outlays in the balance sheet. Another: depreciation effects (accounting profitability is low when a project or business is young and too high as it matures because of straight line depreciation) o a growth in earnings does not mean shareholders are better off

Chapter 4: The Value of Common Stocks • •

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Changes in security prices are fundamentally unpredictable (a natural consequence of well-functioning capital markets). Stock valuation is important: o upon going public o in order to understand what determines stock value, esp. when managers have to act in the interest of the shareholders; that is, when they have to increase shareholder value PV calculation: same as any other asset PV(stock) = PV (expected future dividends)

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Consideration of capital gains? The price in any period is determined by the expected dividends and capital gains. P0 = (DIV1 + P1)/(1+r) because P1 is incorporated in the determination of P0 P1 = (DIV2 + P2)/(1+r) ... DIVt

H

Ergo: P0 = å

t =1 (1 +

r)

t

+

PH (1 + r ) H

, where H is the final period.

In principle, H could go as far as infinity. If it approaches infinity, the PV of the terminal price ought to approach zero. Ergo: ∞

P0 = å

DIVt

t =1 (1 +

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r) t

Stocks with dividends with a constant growth rate (growing perpetuity): P0 = DIV1 / (r - g) , provided that r > g Caution: o g: § Such a simple constant growth formula is only an approximation because a regular future growth is assumed. § Even if the approximation is acceptable, errors will inevitably occur in the estimation of g. § It is not proper for firms with currently high growth rates. It will not likely be sustained. o r: § Any estimate of r for a single common stock is noisy and subject to error. Good practice gives no sufficient weight to single-company cost-of-equity estimates. The average r of similar companies gives a more reliable benchmark. Estimating r: Given the constant growth formula, it holds that: r = DIV1 / P0 + g = dividend yield + growth rate The growth rate will have to be calculated by the analysts. One way to do this is: Plowback ratio = 1 - payout ratio = 1 - DIV/EPS Meanwhile: ROE = EPS / Book equity per share Then: g = plowback ratio x ROE Calculate r accordingly. What if there is no growth? P0 = DIV1 / r = EPS1 / r This also holds when earnings are reinvested. Another form of the DCF formula: FCF = revenue - costs - investments = cash not retained and not reinvested (==> paid out as dividends!) ∞

because P0 = å

DIVt

r) t ∞ FCF t å t t =1 (1 + r )

t =1 (1 +

and thus, P0 = •

Summary: A stock's value represents either: 1. the PV of the expected stream of future dividends 2. the PV of FCFs 3. the PV of average future earnings under no growth: P0 = DIV1 / r = EPS1 / r or the PV of average of future earnings with growth: P0 = (EPS1 / r) + PVGO or P0 = DIV1 / (r - g)

Chapter 7 & 8: Risk and Return, CAPM, OPM ... •

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Risk: the uncertainty of future returns, the spread of outcomes usually measured by the standard deviation/variance If returns are normally distributed, we only need the mean and variance to assess risk and return Diversification: reduces variability: the risk of the PF < sum of the risks of components This is because prices of different stocks do not move exactly together. Putting them together eliminates "unique" risk (= unsystematic risk, specific risk). Market risk is however undiversifiable. This is what matters most in a well-diversified PF. The diversification concept cannot however be transposed to the level of firms. Investors are better off in doing the diversification itself via the securities held in the PF. Firms will just incur high costs and waste time. Value additivity: Diversification does not add to a firm's value or subtract from it. The total value is the sum of its parts. Calculating PF risk 2-stock PF: The variance of the PF = weighted average of the variances + covariance = X12 var1 + X22 var2 + 2 X1 X2 cov1 2 Many stocks: n

Var (PF) = å (Xi Xj varij ) i =1, j=1

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Calculating the contribution of one asset to the PF risk: o Calculate the market risk of the instrument and not the risk of the instrument in isolation ==> Beta! o Security betas determine the portfolio risk. The portfolio beta is the average of the security betas. betai = covim / varm Portfolio selection: According to Markowitz, PF selection consists of increasing expected returns and decreasing s.d. One arrives then at an efficient PF, which gives the highest expected return for a given s.d., or the lowest s.d., for a given expected return. Extension of choices with borrowing and lending: If there is a capital market, then there is a possibility of borrowing/lending at rf. An investor can invest in T-bills and then put the rest of his money in stock. Thereby, he chooses the best PF of common stocks and combines this with borrowing and lending to obtain an exposure to risk that is "satisfactory". If he chooses to lend, he ends up halfway between rf and M. If he chooses to borrow, he extends his possibilities beyond M. At every level of risk, the highest level of expected return is achieved by a mixture of portfolio M and borrowing/lending. CAPM: r - rf = beta ( rm - rf ) r = rf + beta (rm - rf ) The expected risk premium varies in proportion to beta. The equivalent rates of return on all risky assets are a function of their covariance with the market PF. (C/W) Assumptions: o risk aversion o homogeneous expectations o marketable assets, divisibility o no transaction costs; rB = rL o no market imperfections

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o a risk-free asset exists CAPM derivation: grounded on the same idea as that of Markowitz' PF selection together with borrowing/lending (C/W) With the existence of a risk-free asset, investors will choose to hold this and allocate the rest of his endowment in a risky portfolio that lies in the efficient set. No other investor will invest in another PF, because all can do better with this combination of the risk-free asset and the PF, which we will designate as M. (homogeneous expectations) M is the market PF of all risky assets held according to their market value weights. CML: the straight line connecting the risk-free asset and the market PF. Note that the slope is [E(rm) - rf] / s.d.m. This denotes the risk-return tradeoff, given the risk-free asset and M. Now, if all assets are held according to their market value weights, then there should be no extra demand for an individual risky asset such that the slope of the risk-return tradeoff evaluated at M in market equilibrium should equal the slope of the CML. (Rearrange the formulas and solve for E(ri). ==> CAPM If you graph this, the line is called the security market line. It graphs the required rate of return on any asset. Use of the CAPM for valuation: o Risk-adjusted rate of return valuation instead of a discount rate without risk considerations o Certainty equivalent valuation: instead of adding the risk premium to the discount factor, reduce the expected CFs by the risk premium. Applications of the CAPM for corp. policy: o Cost of equity is given directly by the CAPM, because the company's beta is measured by calculating the covariance between the returns of common stock and the market PF. o If projects have different risk levels as the firm as a whole: Estimate the risk of the project and use the CAPM to determine the appropriate required rate of return Points against the CAPM: o The slope of the line has been flat over the years. Defense: That is a long-term consideration. o Returns in the recent years are related to other measures, e.g. firm size and marketto-book ratio, and not beta. Defense: CAPM deals with expected returns and not actual returns. o The CAPM cannot be tested. The true market PF cannot be formed. Still, empirically, investors do require extra returns for taking on risk, and are concerned principally with those risks that cannot be eliminated by diversification, i.e. market risk. APT: the rate of return on a security is a linear function of k factors r = a + b1 (rfactor1) + b2 (r factor2) + ... + noise A diversified PF constructed to have 0 sensitivity (b1 = b2 = 0 ) is risk-free and should be priced to offer rf. Otherwise, arbitrage. A PF constructed to have an exposure to factor 1 will offer a risk premium that varies proportionally with the sensitivity to that factor. Assumptions: o perfectly competitive and frictionless markets o homogeneous beliefs on the linear factor model Why APT is better than the CAPM: (C/W) o not just one beta o no risk aversion assumption / no strong utility function o testable: relative pricing o no assumptions on the distribution of returns

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o easily extended to a multi-period context o no special role for M OPM: can also be applied for the valuation of equity (call option) and debt (put option) Other extensions: determination of dividend policy, capital structure considerations, analysis of convertible debts, warrants and abandonment decisions, valuation of M&As, spinoffs, divestitures and other investment policy decisions. (More in Ch. 20) Note: rf is used here (risk-neutral valuation).

Chapter 9: Capital Budgeting and Risk •

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The company cost of capital is the correct discount rate for projects that have the same risk as the company's existing business but not for those projects that are riskier or safer than the company's average. In the estimation of the beta of a project: o look for similar companies (But what does "similar" mean?... This can also shift over time.) o look at how the stock price has responded to market movements in the past. beta = slope of the line that regresses the rates of return against the market rates o take PF betas or industry betas that are market-value weighted. The standard error thereby is smaller. o set the project beta equal to the asset beta. Reasons: § most projects can be treated as "average" projects § the company cost of capital is a useful starting point for unusually risky projects as compared to estimating each project's cost of capital from scratch. In determining the asset beta, consider cyclicality and operating leverage (fixed production charges that add to the beta of a project) Note that beta is assumed to be constant throughout a project's life. It makes sense to use a single risk-adjusted discount rate for as long as the project has the same market risk at each point of its life. Later CFs are thereby subjected to a higher discounting because they are subjected to a longer market risk horizon. To account for varying risk across time, it may be wise to use probability point masses for possible CFs and separately calculate their NPVs while weighting them to come up with the total NPV.

Chapter 13: Corporate Financing and the 6 Lessons of Market Efficiency •

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Three Forms of Market Efficiency 1. Weak: Prices reflect the information contained in the record of past prices. Stock prices follow a random walk, because if past price changes could be used to predict future price changes, then investors could make easy profits. In competitive markets, such easy profits will not last. All the information in past prices will be reflected in today's stock price and not tomorrow's. 2. Semi-strong: Past prices plus all other published information 3. Strong: All the information that can be acquired by painstaking analysis of the company and the economy. Puzzles and Anomalies o High returns of small firms: Where does the growth come from? Coincidence or CAPM error? Exception to the theory? o Short-term behavior of stock prices: January effect, Monday effect o New issues: subsequent losses o Earnings announcement puzzle: outperformance for stocks of companies boding good news

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o October 1987 crash: Prices fell sharply even though there was no obvious, new fundamental information to justify it 6 Lessons of Market Efficiency 1. Markets have no memory The weak form of efficiency states that the sequence of past price changes contains no information about future price changes. 2. Trust market prices They impound all available information. There is no way for most investors to achieve consistently superior rates of return. 3. Read the entrails If prices impound all available information, then learn how to abstract these information, e.g., identify whether there are abnormal returns or extract the indications of summative investor opinion for prices. 4. There are no financial illusions Investors are concerned with the firm's CFs and their portion thereof. Stock splits, stock dividends, as well as accounting changes, will not trick investors to think that they are better off. 5. Do it yourself Do not pay others to do things you can do. 6. Seen one stock, seen it all Demand for stocks should be highly elastic. If returns are too low, nobody will hold it. If returns are high, everybody will scramble to buy.

Chapter 14 & 15: An Overview of Corporate Financing •

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On average, internal funds make up the bulk of company funds. This could possibly reflect an unjustified reluctance to undertake projects that require external financing. Retained earnings are additional capital invested by shareholders and represent in effect a compulsory issue of shares. This does not affect the opportunity cost of capital in the same way as when a project is financed by depreciation or a new stock issue. Are managers simply taking the line of least resistance and avoiding the "discipline of security markets"? Are they avoiding the costs of new issuances? Is the announcement of a new equity issue considered to be bad news? Recently, firms have issued more debt than equity. But this could not be proven to be a long-term phenomenon. Higher debt ratios mean that more companies will fall into financial distress if there will be a recession. But it need not follow that less risk is better. There is no God-given, correct debt ratio. Overview of Corporate Financing 1. Common stock: issued and outstanding, issued and not outstanding (repurchased shares) Costs of new issues: § Administrative costs § Underwriting costs (+ underpricing costs) New issuance procedure: § Fixed price offer § Auctions 2. Preferred stock: relatively rare but useful in financing mergers: offers a fixed dividend and priority over common stockholders 3. Debt: funded/unfunded debt, subordinated debt, secured/unsecured debt, public/privately placed debt 4. Convertible securities: Warrants, convertible bonds (Chapter 22)

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5. Derivatives: § Options: Instruments with the right to buy/sell an asset in the future at a price agreed upon today § Futures: Advanced orders to buy/sell an asset at a fixed price to be paid at the delivery date § Forwards: Futures contracts not traded in an exchange; usually on foreign exchange § Swaps: Entail an exchange of payment obligations: currency or interest rate Causes of innovation: o Taxes and regulation (avoidance) o To widen investor choice, esp. for hedging o Reduction of costs Points to Note: o There are economies of scale in issuing securities. o Underpricing is a hidden cost for the existing shareholders o The winner's curse: Would-be investors in an IPO do not know how other investors will value the stock. There are worries that they will end up paying for overpriced issues. o New issues may depress the price.

Chapter 16 : The Dividend Controversy • •

The dividend controversy boils down to arguments about imperfections, inefficiencies or whether stockholders are fully rational. Drei Denkansätze 1. Dividendenpolitik hat keinen Einfluss auf den Unternehmenswert. (e.g., Miller/Modigliani 1961) Annahmen: o perfekte Kapitalmärkte, d.h. keine Transaktionskosten o keine Steuern Given that there are no taxes, information asymmetry or transaction costs, the firm can choose any dividend policy without affecting the stream of CFs received by shareholders. Thus, two firms that are identical in every respect except for their dividend payout should have the same value. When there are dividend payouts, this means that the firm will have to give up capital. This capital loss is borne by the shareholders. Thus, dividend payouts and capital losses merely offset each other. Knowing this, it should not matter to investors how high dividends are. Meanwhile, firms ought not worry about dividend policy. 2. Dividenden haben einen Steuernachteil. (e.g., Miller/Modigliani 1963) The best form of payment to shareholders is the one subject to least taxation. As long as the tax rate on capital gains is lesser than the personal tax rate, shareholders will prefer capital gains to dividends. 3. Aktionäre haben eine Präferenz für Dividenden. Dividenden signalisieren zukünftige Unternehmensperformance. The dividend per se does not affect the value of the firm. But it serves as a message from management that the firm is anticipated to do better. Investors can distinguish real money makers from marginally profitable firms through an analysis of dividend policy. If for instance a company reports good earnings and simultaneously pays generous dividends, then it is

B/M Labhart

C/W

B/M

Labhart C/W Labhart C/W B/M

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truly profitable. Firms could possibly pretend this, but pretence cannot last long. Cash is required for that. Dividend policy could affect firm value when investors prefer high payouts and are reluctant to invest in firms that finance mainly through retained earnings. B/M Dividends may take on other forms: automatic reinvestment plans, non-cash dividends, stock splits, share repurchases. Share repurchases relay the information that the firm has accumulated more cash that they can invest profitably. It can also mean that the firm wishes to increase its debt percentage levels. These are not really good news, but investors find this good (more often than not). Empirically, stock prices rise after stock repurchase announcements. Repurchases could signal good future prospects. They can also be taken to mean that the company will not simply waste money. (For firms, the advantage is that this is only one-time, whereas dividend payout is continual.) Rahmenbedingungen der Dividendenpolitik: o Nationale Gegebenheiten (Handelsrecht, Steuerrecht, Finanzmarktpraxis, Volkart etc.) o Branchenbesonderheiten (z.B., Banken mit gesetzlichen Eigenmittelregelungen) o Unternehmensspezifische Charakteristika (KMU, Kapitalmarktbezug, AGs, usw.) o Aktionärsstruktur und privates Vermögen (Mehrheiten und Minderheiten, Familienstruktur, usw.) Für kleine, personen- bzw. familiengebundenen Gesellschaften: kein generell zutreffendes theoretisches Handlungskonzept. Für Eigenkapitalknappe KMU: Berücksichtigung der Kapitalstrukturpolitik und Risikopolitik in Kombination mit den aktionärsseitigen Einkommens- und Konsumpräferenzen. Die Dividendenpolitik fällt direkt mit der investitions- und risikopolitischen Entscheidungsfindung zusammen. Für reine Publikumsgesellschaften: Relevanz vs. Irrelevanz der Dividendenpolitik wie oben dargestellt. Aus steuerlicher Sicht wären unter den heutigen Umständen eher zurückhaltende Ausschüttungen angebracht. Höhe der Ausschüttungen: (Faktoren) o Aktionärspräferenzen: Aktionäre in tieferen Einkommensklassen ziehen Volkart tendenziell höhere Dividenden vor. o Agency-Aspekte: Dividendenzahlungen sind eine Art externe Kontrollgrösse, und der Abfluss verfügbarer Mittel reduziert die Gefahr von Fehlinvestitionen seitens des Managements o Signalling-Effekte: Gesellschaften können mit DividendensatzErhöhungen positive Signale aussenden. In der Praxis dominiert konstante Dividendenauszahlungen gegen der gewinnabhängigen Auszahlungen. Es empfiehlt sich i.d.R. eine stabile Dividendenpolitik. Änderungen führen zu Transaktionskosten und der sogenannter „clientele effect“. (You lose your clients because of the imposed transaction costs.)

Chapter 17 &18: Does Debt Policy Matter?/How Much Should a Firm Borrow? •

The manager has to find the combination of securities that maximizes the value of the firm or that maximizes shareholder value. No complete satisfactory theory has been found for the existence of an optimal

B/M C/W

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capital structure. Casual empiricism suggests that firms behave as though it exists. If there is a target dividend payout, then there must also be a target debt/equity ratio. Miller/Modigliani I: Financing decisions do not matter. Any combination of securities is as good as another. The value of the firm is unaffected by its choice of capital structure. Assumptions: o perfekte Kapitalmärkte, d.h. keine Transaktionskosten o keine Steuern o same borrowing and lending rate o no bankruptcy costs o no agency costs o only two types of claims: debt and equity o all firms of the same risk class In well-functioning markets, two investments that offer the same payoff must have the same cost. Thus, two firms that offer the same stream of operating income and differ only in their capital structure must have the same cost. Therefore, the value of an unlevered firm must equal the value of the levered firm. As long as investors can borrow/lend on their account on the same terms as the firm, they can “undo” the effect of any changes in the firm’s capital structure. Thus, debt policy should not matter. Law of conservation of value: The value of an asset is preserved regardless of the nature of the claims against it. As proposed by value additivity, the value of a firm can be segregated into the corresponding PVs of the components. Firm value is in this case determined by the left side of the balance sheet (i.e., real assets) and not by how much debt and how much equity there are. But MM I does not hold in practice. Financial managers do worry about debt policy: o Taxes play a role. o Bankruptcy is painful. o There are conflicts of interest between the firm’s security holders. o There are incentive effects of financial leverage on management’s investment and dividend payout decisions. Miller/Modigliani II: The value of the levered firm is equal to the value of the unlevered firm plus the present value of the tax shield provided by the debt, i.e., the gain from leverage.

B/M

C/W

B/M

B/M

C/W

B/M

V L = V U + τc B

New assumptions: corporate tax, no personal tax If the government allows the deduction of interest payments on debt as an expense, the market value of the corporation can increase as it takes on more and more debt. But MM Proposition II is an extreme proposition. If the PV of the tax shield C/W increases the after-tax value of the firm, then the firm should ideally take on 100% debt. This is wrong because: o It will appear that debt is fixed and perpetual. It is wrong to think of debt as such. o Many firms face marginal tax rates less than 35%. o Tax shields can only be used when there are future profits to shield. No firm can absolutely be sure of that.

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o There are other factors that offset the PV of the tax shield. Firms incur for example bankruptcy costs. Given corporate and personal taxes: The firm should arrange its capital structure so as to maximize after-tax income. It should try to minimize the PV of all tax paid on corporate income. This includes the personal taxes paid. Extreme levels of debt are also inadvisable because of the risk/return tradeoff. Any increase in expected returns is offset by an increase in risk, and thus, the shareholders’ required rate of return also increases. Moreover: Tradeoff theory of capital structure: Costs of financial distress matter. There is a tradeoff between tax shields and costs of financial distress. VL= VU + PV(tax shield) – PV (costs of financial distress) The theoretical optimum of debt is reached when: PV(tax savings due to additional borrowing) = increases in the PV(costs of distress) Thus, target debt ratios may vary from firm to firm. High ratios are expected from companies with safe, tangible assets and plenty of taxable income to shield. Low target ratios are expected from companies with risky, intangible assets. Effect of bankruptcy costs: If there are bankruptcy costs, then payments must be made to third parties other than bond and shareholders. The value of the firm will be lower than the discounted expected CFs. As the proportion of debt is increased, the probability of bankruptcy increases. Hence, the optimal capital structure results from a consideration of the required rate of return of debt claims. In the end, WACC must be minimized. “Traditional” position: The objective is not just to maximize overall market value but also to minimize WACC. A moderate degree of financial leverage may increase the expected equity return, although not to the degree predicted by Proposition II. Imperfections make borrowing costly and inconvenient. Another factor leading to the violation of M/M II: government manipulations Signalling Hypothesis: There is a projected optimal capital structure. Managers convey information to the market through their financial policy decisions. That includes changes in capital structure and dividend policy. Signals cannot be mimicked by unsuccessful firms. This is also evident in Myer’s pecking order theory. Pecking order theory: Retained earnings, debt, equity. Asymmetric information affects the choice between internal and external financing and between new issues of debt and equity securities. There is no well-defined target ratio. The attraction of tax shields is second-order. Highly profitable firms with limited investment opportunities are the ones with low debt ratios. On the other hand, firms, whose investment opportunities outrun internally generated funds are driven to borrow. Effect of agency costs: There is a trade-off between tax shield benefits and agency costs. There is an optimal capital structure that minimizes agency costs. There are other ways to shield income against tax, e.g., by means of write-offs. Corporate tax shields from debt are worth more to some firms than to others. Firms with plenty of non-interest tax shields and uncertain prospects should borrow less than consistently profitable firms with lots of taxable income to shield.

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Chapter 19: Financing and Valuation •

Weight-Adjusted Capital Cost (WACC) Formula

Berücksichtigung von Ertragssteuern: WACCs =

k FK (1 − s)FK + k EK EK FK +EK

Note: WACCs < WACC, since the tax advantages of debt financing are accounted for. When there are more than two sources of financing: WACCn =

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Skript

k FK + k EK EK Grundformel: WACC = FK FK +EK

k FK (1 − s)FK + k EK EK + k PS PS FK +EK + PS

Note further that only long-term financing is considered in WACC. Leaving out the cost of short-term debt is actually incorrect, except when such is only temporary, seasonal or incidental short-term financing. All the variables in the WACC applies to the entire firm. Thus, the formula will give the right discount rate only for projects, whose cost of capital is just like that of the firm. Entity Approach vs. Equity Approach: The entity approach entails discounting the CFs by the chosen company WACC formula. This implies that the debt ratio is expected to be relatively stable. Under the equity approach, the CFs are discounted at the cost of equity (after interest and after taxes). If the company’s debt ratio is stable, the method should give the same answer as discounting at the WACC and subtracting debt. But this depends on the financial leverage; that is, on the financial risk, as well as the business risk of the firm. If financial leverage will change significantly, discounting flows to equity at the cost of equity will not give the right answer. For banks, the equity approach is the ideal method for valuation purposes. This is because the bank creates value on the liabilities side of its balance sheet. A positive spread that creates value for shareholders comes when the cost of issuing deposits (e.g., interest expenses, check clearing and tellers) is lower than the cost of raising an equivalent amount of funds with equal risk in the open market. The equity approach is appropriate, because it treats liabilities management as part of the business operations. On the other hand, the entity approach is difficult to use, because the cost of capital for non-interest-bearing customer deposits, which are main sources of financing, is then difficult to estimate. Moreover, as the retail bank division is legitimately a separate business, it is quite difficult or impossible to get the discounted value by first valuing its assets via interest income less administrative expenses and then subtracting the PV of the deposit business. Still another problem is the fact that the spread between the interest received on loans and the cost of capital is so low. Small errors in estimating the cost of capital can result in huge swings in the calculated value of equity. Adjusted Present Value (APV): APV is useful when side effects (e.g., costs of issuance, interest tax shields, and government subsidized loans tied to the project) are relevant. Value the project as if it were a firm financed solely by equity. Add or subtract the PV of side effects. Discounting CFs at the WACC and calculating the APV will give nearly identical answers, given consistent assumptions.

B/M B/M B/M

C/K/M

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Adjusted Cost of Capital: This is an adjusted opportunity cost or hurdle rate that reflects the financing side effects of an investment project. The rule is: Accept projects with positive NPVs at the adjusted cost of capital. If you know the adjusted cost of capital, you do not have to calculate the APV. Use NPV and discount at the adjusted cost of capital.

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Chapter 20 & 21: Spotting and Valuing Options and Real Options • •

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Any set of contingent payoffs -- that is, payoffs which depend the value of some other asset -- can be valued as a mixture of simple options on that asset Option Value Boundaries: o Upper bound: Share price o Lower bound: Payoff When the stock is worthless, the option is worthless. When S increases, the option price = S - PV(K). The higher S is, the more probable is the exercise of the option. Investors, who acquire stock by way of a call option, are buying on credit. The delay in payment is valuable, if interest rates are high and the option has a long maturity. DCF will not work for options. o Forecasting expected CFs is messy although feasible o Finding the opportunity cost of capital is impossible, because the risk of an option changes every time the stock price moves (and we know that it will move along a random walk through the option's lifetime). General rule: The higher S is relative to K, the safer the option, although the option is always riskier as the stock. The option's risk changes every time the stock price changes. To value an option, set up an option equivalent by combining common stock investment and borrowing. The net cost of buying the equivalent must equal the value of the option. This is covered by the OPM, discussed subsequently. Black/Scholes Formula: In pricing any option, set up a package of investments in the stock and a loan that will exactly replicate the payoffs of the option. If we can price S and B, we can also price the option. C= S N(d1) - B N(d2), where N(d1) and Nd(2) are cumulative probabilities of the distribution of a standard unit variable Put-Call Parity: Value of Call + PV(K) = Value of Put + S C = P + S - B; P = C + B - S; S = C + B - P Early Exercise of Options? o American Calls (No Dividends): Same as European call, because early exercise reduces its value; B/S applies o American Calls (W/ Dividends): If Div > interest on K; Valuation via the step-bystep binomial method o American Puts (No Dividends): American Put > European Put, American Put – European Put dilution Modifications are necessary to the B/S formula in valuing the warrant. (But such is not needed by the holder, who will simply exercise or not exercise.) Convertible Bond: 1. What it is: The option to exchange the bond for a predetermined number of shares. Thus the owner owns a bond and a call option on the firm's stock. 2. Valuation: Two lower boundaries! The lower bound to the price of a convertible before maturity is the higher of the bond value and conversion value. At maturity, the conversion value serves as the lower bound. To value a convertible, it is then easiest to break the convertible bond into two parts: the bond value and the value of the conversion option. To value the conversion option, look out for dilution and the fact that the convertible owner is missing out on the dividends on the stock. If dividends are higher than the interest on bonds, it may pay to convert before maturity. 3. Effects of the Conversion:

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Conversion has no effect on the total value of the firm's assets, but it does affect how asset value is distributed among the different classes of security holders. The difference between warrants and convertibles: 1. When the owners of the convertible bond wish to exercise the option to buy shares, they do not pay cash. They just give up the bond. 2. Warrants are usually issued privately. 3. Warrants can be detached. 4. Warrants may be issued on their own. 5. Taxation: warrants may reduce the tax paid by the issuing company and increase the tax paid by the investor. Why do companies issue warrants and convertibles? 1. Cash inflow/Better than fresh equity A company that wishes to sell common stock must usually offer the new stocks at 10% to 20% below the market price for the flotation to be a success. However, if warrants are sold for cash, exercisable at 20 to 50% above the market price, the result will be equivalent to selling stock at a premium rather than at a discount. If the warrants are never exercised, the proceeds from their sale will become a clear profit for the company! Options can also be considered as valuable securities, despite the risk and time value involved. If options are properly priced, this will be a fair trade. Its market value is hinged on the stock price tomorrow, which could be favorable. 2. Costly risk assessment Convertible bonds and warrants make sense whenever it is unusually costly to assess the risk of debt 3. Agency Costs Bondholders may be worried that management will not act in the bondholders' interest. 4. Contingent equity A convertible bond that is callable is like a contingent issue of equity. If a company's investment opportunities expand, its stock price is likely to increase, allowing the financial manager to call back and force conversion of the bond into equity. Thus, the company gets fresh equity when it is most needed for expansion. (But it will be stuck with debt, if the company does not prosper.) 5. Low coupon bonds This may be convenient for rapidly growing firms facing heavy capital expenditures.

Chapter 23: Valuing Debt •

Important factor: the discount rate Things to consider: o Consistent treatment of inflation o Term structure of interest rates (graphs the relationship between short-term and long-term rates of interest; plots a series of spot rates over time) Theories: § Expectations Theory f2 = E(1r2) Forward rates of interest must equal expected future spot rates, provided that the investors are interested only in expected return. If the forward rate were less than the expected future spot rate, no one would be willing to hold two-year bonds. The only reason for an upward-sloping term structure is that investors

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expect future spot rates to be higher than current spot rates and vice versa. (This does not say anything about risk...) § Liquidity Preference The term structure is more often than not upward sloping because of the required liquidity premium, which is the difference between forward rates and expected future spot rates. § Inflation Theory Borrowers must offer some incentive if they want investors to lend long, e.g., f2>E(1r2)! This is because future inflation rates are never known with certainty. No one can make a completely risk-free investment. (But the uncertainty here only comes from inflation... What about other risk factors?) § New Theories Price movements are related with each other (based on observations that returns on bonds with different maturities tend to move together) short rates are high ==> long-term rates are high short rates are low ==> long-term rates are low o Yield-to-maturity (a single rate of discount that would produce the same PV as that when each of the payments are discounted at different rates of interest) Problems with YTM: § The same rate is used to discount all payments to the bondholder. The bondholder may actually demand different rates of return for different periods. § Yields to maturity do not determine bond prices. It is the other way around. § It is a complicated average of spot rates. It hides much interesting info. § Returns calculated do not add up. o Duration: average time to each payment A firm can ensure that the value of the bonds held is always sufficient to meet the liabilities by making sure that the duration of the bonds is always the same as the duration of the pension liability. o Volatility: summary measure of the likely effect of a change in interest rates on the bond value. It is related to duration; that is, vola = duration / (1 + yield) o Probability of default: The reason why some borrowers have to pay a higher rate of interest than others. This is normally depicted in bond ratings, which are judgments about firms' financial and business prospects. The key figures for the determination of the bond rating includes the following: debt-equity ratio, earnings-to-interest ratio, ROA. Since bond ratings reflect the probability of default, there is a close correlation between the bond rating and the promised yield. Bond Valuation as an Option: o A corporate bond = lending money with no chance of default but at the same time giving the stockholders a put option on the firm's assets. When a firm defaults, its stockholders are in effect exercising their put. B = bond value with no default - P Two-step bond valuation: 1. Calculate the bond value assuming no default. Discount the promised interest payments and the principal at the rates offered by Treasury issues. 2. Calculate the put value.

Note that the maturity of the put equals the maturity equals the maturity of the bond. K = promised payment to bondholders o A corporate bond = owning the firm's assets but giving a call option on the assets to the stockholders. B = asset value - C ==> If you can value puts and calls on a firm's assets, you can value its debt. Chapter 24: The Many Different Kinds of Debt See Volkart Skript.

Chapter 25: Leasing •

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Lease = a rental agreement on a series of payments that extends for a year or more. It is an alternative to buying capital equipment. For operational leases, the decision centers on "lease vs. buy". For financial leases, the decision centers on "lease vs. borrow". Why lease? 1. Short-term leases are convenient. 2. Cancellation options are available. 3. Maintenance is provided. 4. Standardization leads to low administrative and transactions costs. 5. Tax shields can be used. If you can devise a borrowing plan that provides the same future cash outflows as the lease but a higher immediate CF, then you should not lease. However, if the equivalent loan provides the same future cash outflows as the lease, but a lower immediate inflow, then leasing is the better choice. A financial lease is superior to buying and borrowing if the financing provided by the lease exceeds the financing generated by the loan. Valuation of a lease: Construct a table showing the equivalent loan (difficult) or discount the lease CFs at the after-tax interest rate that the firm would pay on an equivalent loan. Net value of lease = initial financing provided - discounted summation of lease CFs Not a zero-sum game: Both the lessor and the lessee can "win" if their tax rates differ. The highest gains are achieved when: o The lessor's tax rate is substantially higher as the lessee's. o The depreciation tax shield is received early in the lease period. o The lease period is long and the lease payments are concentrated toward the end of the period. o The interest rate is high. If it were 0, there would be no advantage to postponing tax in PV terms.

Chapter 26: Managing Risk • •

Insurance and hedging are at best 0-NPV transactions. The aim is risk reduction. Insurance deals may however not have 0-NPVs because of the costs that the insurance company incurs. Hedging:

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o Futures: A commitment to buy/sell an asset/commodity in a standardized market at a future time, while fixing the price today. A margin is normally put up, and the value is marked to market. Advantage: You can gain interest on the still unpaid price Disadvantage: You miss out on the dividend paid in the meantime. Financial assets: PV(futures) = Futures price/(1 + rf) = spot price - PV(dividends or interest payments forgone) Commodities: PV(futures) = Futures price/(1 + rf) = spot price + PV(storage costs) - PV(convenience yield) o Forwards: Unstandardized futures o Swaps: Currency swaps, interest rate swaps, default swap (credit derivative). How to set up a hedge: Expected change in value of A = a + δ(change in value of B) δ measures the sensitivity of A to changes in the value of B ==> hedge ratio: the number of units of B which should be sold to hedge the purchase of A. One minimizes risk by offsetting the position in A by selling delta units of B. Assumptions: o A is owned o Percentage changes in the value of A follow the specified relationship The question is: How is the hedge ratio determined? Historical data may help. Another method: via duration and PVs (matching assets and liabilities) The option delta: summarizes the link between the option and the asset. Options can thus be used for hedging. Any change in the value of the stock position can be offset by a change in the value of the option position. Note: Option deltas change as the stock price changes and time passes. Therefore, optionbased hedges need to be adjusted frequently.

Chapter 27: Managing International Risk •

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Points to consider: o Interest rate parity theory: Money can otherwise be easily moved. o Equal real interest rates o Expectations theory of forward rates: On the average, the forward rate is equal to the future spot rate. A company that covers its forex commitments does not pay extra for this insurance. o Purchasing power parity Practical Implications: o Use forward rates to adjust for FX risk in contract pricing. o The expectations theory suggests that protection against FX risk is usually worth having. o On the basis of interest rate parity, hedge by either selling a forward or borrowing forex and selling spot. o The cost of forward cover is not the difference between the forward rate and today's spot rate. It is the difference between the forward rate and the expected spot rate when the forward contract matures. Exchange risk and international investment decisions: If Roche, for example, ignores currency risk and discounts the dollar CFs at a dollar cost of capital for its US investments, it is assuming that the currency risk is hedged. This is equal to calculating the CFs in SFR and discounting this at the SFR cost of capital.

Chapter 28: Financial Analysis and Planning •

Financial ratios: a convenient way to summarize large quantities of financial data and to compare firms' performances. They assist in asking the right questions but seldom answer them. 1. Leverage Ratios: show how heavily the company is in debt § Debt ratio = (long-term debt + value of leases)/(long-term debt + value of leases + equity) ==> ratio of long-term debt to long-term capital § Debt-equity ratio = (long-term debt + value of leases)/equity The abovementioned ratios use book rather than market values. Market values are often not available. It does not probably matter much, because market values include the value of intangible assets, and these are not readily saleable. § Time-Interest-Earned (Interest Cover) = (EBIT + depreciation)/interest ==> The extent to which interest is covered by EBIT plus depreciation Rationale: Regular interest payment is a hurdle that companies must duly face up to. 2. Liquidity Ratios: measure how easily the company can lay its hands on cash § Current ratio = current assets/current liabilities ==> measures the margin liquidity Rapid decreases in the current ratio sometimes signify trouble. However, they can be misleading. At times, the net working capital is not affected by short-term financial decisions and yet the current ratio changes. For this reason, it may be good to take away short-term investments and debt. § Quick ratio (acid test) = (cash + short-term securities + receivables)/current liabilities Idea: Some assets are closer to cash than others. § Cash ratio = (cash + short-term securities)/current liabilities Only the most liquid assets Note: None of the standard liquidity measures takes the firm's reserve borrowing power into account. Lenders however look into liquidity ratios because of their reliability as against book values. 3. Efficiency Ratios: indicate how productively the company is using its assets § Sales-to-Assets Ratio (Asset Turnover) = sales/average total assets ==> how hard are the firm's assets being used? A high ratio means that the firm is working close to capacity. It may be difficult to generate further business without an increase in invested capital. § Days in Inventory = average inventory/(cost of goods sold/365) ==> the speed with which a company turns over its inventory; the number of days that it takes for the goods to be produced and sold A low level of inventories is often regarded as a sign of efficiency. But it may indicate simply that the firm is living from hand to mouth. [Inventory Turnover = cost of goods sold/average inventory] § Average Collection Period = average receivables/(sales/365) ==> how quickly do cusotmers pay their bills A low ratio indicates an efficient collection department but could mean an unduly restrictive credit policy. 4. Profitability Ratios: show the returns that the firm earns from investments § Net Profit Margin = (EBIT - tax)/sales ==> the proportion of sales that finds its way into profits

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Return on Assets = (EBIT - tax)/average total assets (or ROI) ROE = earnings available for common stockholders/average equity § Payout Ratio = Dividends/Earnings ==> the proportion of earnings that is paid out as dividends 5. Market Value Ratios: show how highly the firm is valued by investors § P/E ratio = Stock price/EPS ==> measures the price that investors are prepared to pay for each dollar earnings High P/E ratios: investors think that the firm has good growth opportunities or its earnings are relatively safe and therefore more valuable. This could however also mean temporarily low earnings. § Dividend yield = Dividend per share/stock price ==> the expected dividend as a proportion of the stock price Low dividend yield: investors are content with a relatively low rate of return or are expecting rapid growth in dividends that could bring in capital gains. § Market-to-Book ratio = Stock price/Book value per share [Book value per share = stockholders' book equity (net worth)/number of outstanding shares] [Book equity = common stock + retained earnings] ==> how much is the firm worth in comparison to what the past and present shareholders have put into it § Tobin's q = market value of assets/estimated replacement cost ~ market-to-book ratio. The difference is that the numerator includes all debt and equity securities and the denominator includes all assets. There is an incentive to invest when q > 1, i.e., capital equipment > cost of replacement. It may be cheaper to acquire assets through mergers when q < 1. Accounting Definitions: Things to think about when interpreting financial ratios: o Depreciation and deferred tax o Intangible assets (expenditures that create valuable assets that may generate future CFs) o Goodwill o Off-balance sheet debts (esp. short-term leases) o Pensions o Derivatives o Foreign accounting practices Examples on the use of financial ratios: 1. Bond issuance: The financial manager looks into the prudence of new borrowings and whether the leverage is within the standard practice levels. He thus looks at the debt ratio and times-interest-earned ratios. The rating agencies look at the creditworthiness of the firm and their ability to service new debt. They then also look at leverage ratios. The lenders are interested in bond quality. They also look at the leverage ratios. 2. Review of operations to identify which activities should be shut down or expanded: The manager looks at the ROA of each business. The shareholders do the same and welcome high ROAs. Consumer groups and regulators do likewise, but as ask: if there is a high ROA, is the firm charging excessive prices?

3. By means of financial ratios, "accounting betas" may also be calculated. This is the sensitivity of each company's earnings to changes in the aggregate earnings of all companies. This can help in predicting bond ratings. Chapter 29: Short-Term Financial Planning • •

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Short-term financial decisions involve short-lived assets and liabilities. This is because they are easily reversed. The financial manager does not have to look far into the future. The cumulative capital requirement -- the total cost of assets -- should be financed by either long-term or short-term financing. Short-term capital comes in when the firm must make up for the difference between cumulative capital requirements and long-term financing. If long-term capital is overflowing, surplus cash can be allotted for short-term investments. The financial manager's task is to forecast future sources and uses of cash Cash budgeting: Inflows and outflows Short-term financing plan: developed by trial and error Alternatives for short-term financing: 1. Unsecured bank borrowing 2. Stretching payables - defer payment of bills (often costly because discount for early payments are missed)

Chapter 30: Credit Management ==> management of accounts payable, accounts receivable •

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Steps: 1. Fix terms of sale 2. Decide whether to sell an open account or ask customers to sign IOUs 3. Which customer should be offered credit? Credit analysis: o ratings agency indications o financial ratio analysis o numerical credit scoring: decisions to grant credit are made on the basis of a scoring system

Chapter 31: Cash Management •

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Cash is held for liquidity. The marginal value of this liquidity = marginal value of the interest on an equivalent investment in T-bills A sensible balance has to be found for the proportion wealth held in cash and in securities. Essential points in cash management: o Trade-off between the benefits and costs of liquidity o Making sure that the collection and disbursement of cash is efficient Cash vs. Inventory: Miller/Orr Model Inventories have carrying costs. The optimal order size, given order costs, is hence when: marginal reduction in order cost = marginal carrying cost This formula could be carried over to the choice between T-bills or cash. The relationship is per Baumol: Q = square root of [(2*annual cash disbursement*cost of selling T-bills)/interest rate]

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If interest rates are high, the firm should hold smaller average cash balances and make smaller and more frequent sales of T-bills. (low Q) If the firm uses up cash at a high rate or incurs high costs in securities, it should hold larger cash balances. (high Q) Note: This does not consider net inflow of cash vis-à-vis net outflows. (Such can be forecasted.) It highlights the basic trade-off that the cash manager needs to make between the fixed cost of selling securities and the carrying costs of holding cash balances. Two reasons for holding significant amounts of cash: 1. Cash may be left in non-interest bearing accounts to compensate banks for the services they provide. 2. Large corporations may have literally hundreds of accounts. It is often better to leave idle cash in some of these accounts than to monitor them daily and make daily transfers. (Why many accounts? - decentralized management)

Chapter 32: Short-Term Lending and Borrowing • •

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Short-term lending: in the money market Valuation: In general, the danger of default is less, because: o the range of possible outcomes is smaller o only well-established companies borrow in the money market. (Nevertheless, there are often significant differences in yield between corporate and government securities. This is due to the risk of default on commercial paper, as well as the different degrees of liquidity. T-bills can be easily turned to cash on short notice.) Yield: o Many are pure discount securities (no interest). The return consists of the difference between the amount you pay and the amount you receive at maturity. o It is difficult to find out the yield of money market securities: 1. rates are often quoted on a discount basis 2. usually quoted on a 360-day year Ex. Price of a 91-day bill = 100 - 91/360 * 4.36 = 98.898 Given that the face value = 100 and it is selling at a discount of 4.36%.

Chapter 33: Mergers • •

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A merger adds value only if the two companies are worth more together than apart. Types: o Horizontal merger: same line of business o Cross border: in two different countries o Vertical merger: companies at different stages of production o Conglomerate merger: unrelated lines of business Motives: o Economies of scale (horizontal mergers) o Economies of vertical integration (vertical mergers) o Complementary resources o Unused tax shields o Surplus funds o Elimination of inefficiencies; better management (not essentially out of the benefit of combining two firms) Takeover Battles and Tactics: o Shark-repellent charter amendments: § Staggered board: 3 groups, only one group is elected every year

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Supermajority: 80% have to approve a merger Fair price: Mergers are allowed only when a fair price is paid. Restricted voting rights: if they own more than a specified proportion of shares § Waiting period: passage of time before merger completion o Poison pills: Existing shareholders are given the right to purchase additional stocks at a bargain price o Poison put: Existing bondholders can demand repayment in a hostile takeover Post-Offer Defenses: o Litigation - Anti-trust o Asset restructuring o Liability restructuring

Chapter 34: Control, Governance and Financial Architecture • • •

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Corporate control: the power to make investment and financing decisions Corporate governance: the role of the board of directors, shareholder voting, proxy fights and other actions taken by shareholders to influence corporate decisions. It entails the mechanisms by which managers are led to act in the interest of the shareholders. Financial architecture: the financial organization of a business; partly corporate control and corporate governance plus legal form, sources of financing, and relationships with financial institutions Where financial architecture differs, governance and control are different too. Leveraged buyouts vs. ordinary acquisitions: o A large fraction of the purchase is debt-financed o The LBO goes private; its shares will no longer trade in the open market. (It is held by a partnership of usually institutional investors. When this group is led by the company's management, the acquisition is called a management buyout.) Motives of LBOs: o Junk bond markets - cheap financing o Leverage and taxes o Motivates managers to work harder Spin-off: o a new, independent company created by detaching part of a parent company's assets and operations o not taxed so long as shareholders in the parent are given at least 80% of the shares in the new company o management can concentrate on the spin-off's main activity. Moreover, it is easier to see the value and performance of managers. o good news for investors: funds will not be siphoned to unprofitable businesses. This is a focused firm. Carve-outs: like spin-offs, but shares are sold in a public offering; subject to corporate tax Privatization: a sale of a government-owned company to private investors Motives: increased efficiency, share ownership, revenue for the government Conglomerates: o Pros: § Good managers could effectively manage firms involving many business areas and take advantage of complementarities, etc. § Possibility of an internal capital market o Cons: § It is not a real internal market.

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Shareholders can diversify better. Possibility that misallocations could just end up with a subtraction in value rather than an addition Keiretsu: a network of companies usually arranged around a bank; a system of corporate governance where power is split between the main bank, the largest companies and the group as a whole.